Why are the REIT markets in Germany and the US poles apart in size and maturity? Sven Helmer and Robert Borden seek some answers
The US real estate investment trust (REIT) market has been in existence since the 1960s and is an important and well-established investor in the US commercial real estate market. The German REIT market is still in its infancy, having been established in 2007, and has yet to develop into a dominant institutional investor market. A comparison of US and German REITs illustrates a few important differences between the two investment vehicles (due to the small number of true German REITs, for purposes of comparison, other non-REIT listed companies were included).
At the end of 2010, the market cap of US REITs was $389bn and REITs accounted for roughly 10-15% of institutionally-owned real estate, according to NAREIT's January 2011 REITWatch report. Meanwhile, the European Public Real Estate Association (EPRA) estimates the listed property sector accounts for roughly 1.5% of the total commercial market in Germany. The stark difference in market share between US REITs and the listed German property sector begs the question: what is inhibiting the German market? In all likelihood there is not a single determining factor that if changed will reshape the German listed property sector, but more likely multiple small changes over time will help develop the market.
Is a specific market or asset expertise required to promote investment? The US REIT market comprises roughly 154 REITs with a wide range of property sector specialisations. The German market contains less than 20 listed property companies, which makes a direct comparison difficult. What is clear from the US data is that a mature market can handle a large number of REITs with varying degrees of asset focus. Comparing the share price development of the largest US REIT (by market cap) in each sector (office, retail and residential) with the largest diversified REIT shows that all three REITs with a clear asset focus outperformed the diversified REIT.
A key component for all investments is liquidity. Real estate by nature is not a liquid investment. The superior liquidity a REIT affords, compared to directly or indirectly investing in real estate, is a key differentiator. The average daily trading volume of US REITs is close to seven times the average volume of the listed property sector in Germany. In addition, a sample of 10 small to mid-sized US REITs resulted in an average float of approximately 94% compared to 77% for the sample of German listed companies. Establishing a greater amount of liquidity in the listed property sector will benefit the growing market by increasing the number of investors and the number of indices the companies are included in.
Accounting rules for the US and Germany are different. US companies report based on US GAAP and Germany reports based on IFRS. One of the key differences, in relation to REITs, is between fair value reporting and depreciation. Under US GAAP, real estate assets are held on balance sheets at historical cost and depreciated. Under IFRS, the assets are reported at either fair value, which is established by an impartial third party appraiser, or at historical cost and depreciated. Fair-value reporting creates increased balance sheet volatility as assets are continually marked to market. In comparison, the depreciation method creates less unexpected changes in the balance sheet, but it does create more uncertainty as to the true value of the underlying real estate assets.
Comparing the volatility of the German listed-property sector against the DAX and a selection of US REITs against the S&P 500 reveals a higher volatility in the US REITs. US REITs were 38% more volatile than the S&P over the past three years, and the German listed property companies were 27% more volatile than the DAX. What makes this finding even more surprising is that the German companies typically have higher leverage than their US counterparts. Accounting is not the only factor governing the volatility of the two markets but it does support the continued use of fair value reporting.
Leverage appears to be a key difference between the US REIT market and the German listed property market. US REITs typically have low leverage, which protects them from foreclosures and insulates distributions from erosion during economic turmoil or lease rollover. The average debt ratio of US REITs, according to NAREIT's August REITWatch report, was 45%. The average debt ratio of the German sample was 69%, according to Bloomberg data. A key goal of purchasing a REIT is the cash distribution. Investors seeking real estate for cash flow as opposed to capital appreciation need distribution security, which is not provided by highly leveraged companies. The inflated debt levels of the German listed property sector will be an obstacle for increased institutional investment, especially when considering real estate's central roll in the most recent recession.
As mentioned above, dividends are a driving force behind the appeal of REITs. The US REIT industry has a strong track record of distributions. According to REITWatch, from 2008 to 2010 roughly 91% of US REITs distributed a dividend on any given year. As of August 2011, the cash dividend of US REITs was 4.44% compared with 2.12% for the S&P 500. In Germany, the annual distribution of dividends by the listed property sector must improve to warrant increased investment. In the past three years, on average, only two-thirds of the listed property sector distributed a dividend in any given year, and the median yield was 2.21%, according to Bloomberg data. The appeal of real estate investment is recurring income, and much of the German listed property sector is not catering to investors' demands for cash distributions.
A comparison of the shareholder composition of US REITs and the German listed property sector illustrates a key difference and an important building block for the German sector. The US market is dominated by investment from major institutional advisers like Vanguard, Blackrock, State Street, and Fidelity, while the German sector is still controlled by the initial owners. Investment advisers make up on average 25% of the ownership of the German listed property sector, according to Bloomberg data. Based on a sampling of US REITs, investment advisers make up on average 81% of the ownership. Increased participation by investment advisers is a key goal for the German listed property sector, which would provide the promising market with a capital infusion.
The German listed property sector is a market ripe for growth. Investors looking to participate in German real estate have historically relied upon open-ended real estate funds, which continue to dominate the investment landscape. The past recession exposed a lack of liquidity with many of these funds. The listed property sector has the ability to take market share from the open-ended funds; improving a few areas of the listed property sector will help achieve this.
Sven Helmer is European director, and Robert Borden is principal consultant at JLL